This blog will unpack the concept of “Basis Risk” when it comes to insurance.
Basis risk is a technical financial term that when applied in the insurance context means that the insurance payment received after making a claim does not equal (or indemnify) the full cost of that claim event. In simple terms, it’s when the customers expectation of the policy payout doesn’t match what they thought they would receive. Basis risk results in a mismatch in expectations between the insurer and the customer.
A recent example of basis risk can be seen in the numbers of complaints resulting from the insurance response to the COVID pandemic. Many businesses assumed that they were covered, but they were not covered for Non-Damage related business interruption, resulting in claims being declined by the insurer. The primary driver behind complaints comes from a disconnect between what customers thought they had cover for, and what they were actually paid when the pandemic hit. This dissatisfaction impacts insurers and brokers and can culminate in bad press and reputational damage for the industry.
Basis risk applies to traditional indemnity-based insurance policies as well as parametric insurance policies.
Basis risk often comes with terms that might reduce or exclude money during a claim settlement. In the traditional world basis risk can result from policy conditions such as:
This is the easy one. An excess means that customer is liable for a certain proportion or value of any claims, and that they will pay the first $X towards their recovery. In New Zealand, customers are familiar with the application of excesses. For example EQC applies a 1% excess on payment (up to$3,000) while traditional policies generally apply an excess of at least $5,000 on a natural disaster claim. If you run a business or own commercial property then you are likely to have an excess deductible of 5% of the sum insured amount, if not up to 10% in more seismic locations.
This is like an excess but applies to a Business Interruption policy. A deferment period is a condition where the customer is liable for financial impact for the first initial period after an event. There is typically a deferment period of 21-days before the business interruption policy kicks-in. This is a risk sharing condition that ensures that customers cover the first response to a natural disaster.
Exclusions are often the focus in the headlines when claim payments fall short of expectations. To be fair, insurers and brokers are always careful to point out exclusions when they do apply in a policy, however the implications of this is sometimes not fully understood by the customer until a claim is in the process of being settled. An example of a complex exclusion is the impact of a “de-population clause” in a business interruption policy. This exclusion impacted many businesses located in Christchurch when the CBD was cordoned-off (for 859 days!) after the Canterbury quakes.
These are complex events. The resolution of claims resulting from a natural disaster event can take months, if not years. The long-tail resolution trajectory results in additional impacts, including further loss deterioration (i.e. additional wear-and-tear from prolonged exposure to the weather), and increased costs of repair and rebuild due to resources constraints and building inflation. We certainly saw this impact after the Canterbury and Kaikoura quakes, and I would anticipate that we will unfortunately see similar trends emerge out of the Auckland floods and Gabrielle.
In the parametric world, basis risk emerges when the correlation between the pre-agreed payment structure and amount that is paid is different from the loss that is sustained by the customer. In this context, basis risk comes from the trigger measurement or the chosen payout.
The key part of a parametric policy is designing the trigger. You can think of the trigger as a proxy for damage, so it is important that the trigger is chosen to closely correlate with the loss experience by the insured.
Fortunately, or unfortunately as the case maybe, New Zealand has a lot of good data on earthquake events, so Bounce has been able to use this data to inform our trigger threshold ensuring that it is related to our lived experience. That is why Bounce uses the Peak Ground Velocity (PGV) metric as a trigger because it provides a more accurate representation of the amount of ground shaking (i.e. earthquake intensity), and therefore damage, that can result from an earthquake.
Basis risk can also creep in where there is a distance from the measurement to the insured location. The further away that the insured location is from a measuring point, the greater the chance of basis risk. That’s why Bounce uses GeoNet strong motion sensors located around the country because these provide a good localised representation of earthquake risk, while at the same time reducing the chance of basis risk for the customer.
The second potential source of basis risk in parametric covers relates to the selection of payout values, i.e. the sum insured amounts selected by the customer and broker. To reduce the risk of underpayment or overpayment it is important to consider what needs protecting and where there are the gaps in the customers’ existing insurance covers before taking out parametric covers. For example, a household might calculate that their accumulated excess is $8,000 ($3,000 for EQC and $5,000 for traditional house policy) plus they may want some funds for additional recovery expenses so they might select a $20,000 sum insured policy. Similarly, a small business with 100 staff might select a parametric policy with sum insured value of $250,000 to cover the first 2 weeks after an event (100 staff ×8 hours per day × $30/hour × 10 days = $240K + some amount for lost productivity).
Basis risk is an accepted part of the insurance world and often results in customers feeling short-changed when a claim settlement doesn’t meet the full costs of repair or reinstatement, i.e. their expectations. Experience highlights the importance of traditional insurance for indemnifying the insured from loss, but we also know that the claim settlement process can be complex, stressful, and time consuming. We also know that traditional insurance does not respond to the immediate financial needs of customers, whereas parametric insurance is all about protecting the cash flow.
Parametric insurance goes hand-in-hand with traditional covers. Parametric provides the cash for initial response while traditional insurance provides the funding for the rebuild.
From a customer perspective, a combination of solutions can significantly enhance the broader customer experience while at the same time reducing basis risk and minimising reputational risks for brokers and insurers after a crisis.
